Lecture 1 money and banking 28 eight basic facts 1

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Lecture 1: Money and Banking 28
Eight Basic Facts 1. Stocks are not the most important sources of external financing for businesses 2. Issuing marketable debt and equity securities is not the primary way in which businesses finance their operations 3. Indirect finance is many times more important than direct finance 4. Financial intermediaries, particularly banks, are the most important source of external funds used to finance businesses. Lecture 1: Money and Banking 29
Eight Basic Facts (cont’d) 5. The financial system is among the most heavily regulated sectors of the economy 6. Only large, well-established corporations have easy access to securities markets to finance their activities 7. Collateral is a prevalent feature of debt contracts for both households and businesses. 8. Debt contracts are extremely complicated legal documents that place substantial restrictive covenants on borrowers Lecture 1: Money and Banking 30
Asymmetric Information Asymmetric information arises when insufficient information of the one party involved in a transaction makes it impossible to make accurate decisions when conducting the transaction Adverse selection occurs before the transaction: Bad borrowers are the ones most likely seeking to borrow Moral hazard arises after the transaction: The lender runs the risk that the borrower will engage in more risky activities after the loan has been agreed, making its repayment more risky Agency theory analyses how asymmetric information problems affect economic behavior Lecture 1: Money and Banking 31
Adverse Selection: The Lemons Problem If quality cannot be assessed, the buyer is willing to pay at most a price that reflects the average quality Sellers of good quality items will not want to sell at the price for average quality The buyer will decide not to buy at all because what is left in the market is poor quality items This problem explains fact 2 and partially explains fact 1 Lecture 1: Money and Banking 32
Adverse Selection: Solutions Private production and sale of information Free-rider problem Government regulation to increase information Not always works to solve the adverse selection problem, explains Fact 5. Financial intermediation Explains facts 3, 4, & 6. Collateral and net worth Explains fact 7. Lecture 1: Money and Banking 33
Moral Hazard in Equity Contracts Called the Principal-Agent Problem Principal: less information (stockholder) Agent: more information (manager) Separation of ownership and control of the firm Managers pursue personal benefits and power rather than the profitability of the firm Lecture 1: Money and Banking 34
Principal-Agent Problem: Solutions Monitoring (Costly State Verification) Free-rider problem Fact 1 Government regulation to increase information Fact 5 Financial Intermediation Fact 3 Debt Contracts Fact 1 Lecture 1: Money and Banking 35
Moral Hazard in Debt Markets Borrowers have incentives to take on projects that are riskier than the lenders would like.

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